Microsoft Anti-trust Trial

Interview with Nicholas Economides

Last Friday, Judge Jackson anounced his decision on the “findings of
fact” in the Microsoft case. An expert on Industrial Organization and the
Microsoft case, Professor Economides of the Stern School
of Business at NYU has again agreed to answer some questions on the trial
and the findings.

Nicholas Economides is a Professor of Economics at the Stern
School of Business, New York University. He earned his Ph.D. from University
of California at Berkeley and previously taught at Columbia University
and Stanford University.

Economides has published extensively on networks, network pricing, market
structure and other topics. He has edited a special issue of the International
Journal of Industrial Organization on Network Economics and is currently
working on a book entitled The Impact of the 1996 Telecommunications
Act to be published by the American Enterprise Institute and MIT Press.

Let me first note that I am not now and have never been involved in
any litigation involving Microsoft.

When Judge Jackson announced some time ago that he would release his
decision on findings of fact before his decision on the findings of law
(which are typically released together), many thought that the judge’s
decision on the “findings of fact” would be moderate, and the two parties
would be urged to settle the case before the release of the “findings of
law.” The incentive for Microsoft to settle before the findings of law
are released would have been to reduce the probability of civil antitrust
suits that would be based on a decision by the judge that found Microsoft
guilty of monopolization and other wrongdoings. (Remember the judge’s findings
of fact do not constitute a conviction.) There are two incentives for settling
by the plaintiffs. First, there does not seem to be a remedy that would
take care of the antitrust problems without creating possibly bigger efficiency
losses (see further analysis below). Second, it is desirable to reduce
the expenditure of the public’s money. Thus, on the eve of the judge’s
decision on findings of fact, the expectation was that the decision would
be moderate, so the parties would settle. The decision was expected to
be adverse for Microsoft because the judge had let it be known that the
decision would be announced on a Friday at 6:30, after the close of the
main US financial markets. Hence, the judge was expected to rule moderately
for the plaintiffs.

What were your initial reactions to the judge’s findings of fact?

The “findings of fact” as decided by the judge on November 5, in almost
all points, are favorable to the plaintiffs. In fact, it is hard to find
even one major allegation for which the judge did not decide on facts that
directly support the plaintiffs’ positions. The judge was unusually harsh
to Microsoft.

What were your subsequent reactions to the judge’s findings of fact?

In closer examination, the “findings of fact” are weak and not very
well justified. The judge fails to argue convincingly about:

The “fact” that consumers were harmed by Microsoft’s actions;

The “fact” that Netscape posed a real threat to Microsoft’s operating system,
and that therefore that the browser integration in Windows was done to
thwart such competition.

Were consumers harmed by Microsoft?

The judge finds the “fact” that consumers were harmed. The plaintiffs’
lawyers (including the US Attorney General) hailed the judge’s findings
of fact as “a great victory for American consumers.” But is it really?
Microsoft gave away the browser. Before Microsoft pursued this policy,
Netscape was a monopolist in the browser market charging $40-50 per unit.
Consumers have directly saved about $2 billion by Microsoft’s free browser
distribution and bundling policy that the judge found to be anti-competitive!
Why does this benefit to consumers escape Judge Jackson’s notice?

Moreover, consumers have directly benefited from the relatively low
price of Windows ($40-50 to computer manufacturers) compared to historical
prices of operating systems and current prices of other operating systems.
For example, IBM was selling OS/2 (which ran much fewer applications than
Windows) for hundreds of dollars. Some Linux packages (that are essentially
add-ons to the free Linux source code) that run very few applications (compared
to Windows) sell for $150. If Microsoft can exercise all this monopoly
power as the judge finds, why is Microsoft so benevolent and does not charge
more?

The judge found that Microsoft had the ability to exercise pricing power
but does not fully do so. This is very hard to believe. Presently
Microsoft is worth $400 billion, with the Windows division and the applications
division worth each about half of that. So, the Windows division
of Microsoft is worth about $200 billion with Microsoft charging $50 per
Windows 98 unit. The same division would be worth at least $400 billion
if MS charged $130 per Windows 98 unit. The judge’s findings of fact
imply that Microsoft forgoes an increase of its market value by $200 billion
so that it can act anti-competitive and extend its monopoly power in other
markets. This is almost mathematically impossible because the value
of MS from all the other markets (including markets with no allegations
of anti-competitive acts) is $200 billion. So, Microsoft charges way below
the monopoly price and consumers benefit from it. Before DOJ splits
Microsoft into three parts, it better make sure that the triopoly price
with each baby MS having only one third compatible applications is in fact
lower than what MS charges now.

Was Netscape a serious threat to Windows?

I seriously doubt it. Netscape had not even taken the preliminary
steps to create a rudimentary operating system that would run on top of
its browser. Although a possibility of the creation of such system
existed (based on Java or otherwise) in principle, there was no evidence
that Netscape was on its way to doing so.

Do you think a settlement is now more likely?

No. Given the across-the-board siding of the judge with the plaintiffs,
a negotiated settlement seems extremely unlikely in the short run. The
terms of a settlement would be based on the “findings of fact” that are
very adverse to Microsoft. Microsoft is unlikely to settle on terms implied
by such adverse findings. Moreover, in a similar case about 15 months ago,
the Appeals Court ruled that Microsoft had the right to include whatever
it wanted in the PC Operating System, including its browser. So, Microsoft
can reasonably expect that the same Appeals Court will rule similarly on
appeal, reversing a significant part of the findings of fact of Judge Jackson.
On the other side, there are 20 plaintiffs (USDOJ and 19 States). It would
be hard for all 20 to agree on major concessions in settlement talks given
the very favorable findings of fact. Thus, Microsoft is likely to wait
for the final ruling on liability, fight the remedies battle, and keep
appealing.

Are there any additional factors that are likely to weigh in the
probability of settlement?

There are two additional factors that make it more likely that Microsoft
would prefer to wait. First, Microsoft has argued in court that the landscape
changes quickly and radically in the software industry, citing the Netscape
buyout by AOL and Sun. The longer the duration of the case, the more likely
it is that more such radical changes will happen before the final decision
is made. Second, it is likely that the final appeal will end during the
next US Administration. This may be beneficial to Microsoft, since a different
Administration may be much softer on antitrust issues.

Is there any factor that may increase the incentive of Microsoft
to settle?

A conviction of Microsoft on monopolization will open the doors to private
antitrust suits against Microsoft. This could be costly to Microsoft,
but, in my opinion, it is not of critical importance to Microsoft.
The most crucial issue for Microsoft is how to make sure it preserves and
appropriately utilizes its management. Federal litigation has imposed
on Microsoft the threat of a breakup that could cripple Microsoft’s ability
to manage itself efficiently. Microsoft clearly sees this as a threat
and will fight it. At the same time, Microsoft should guard against
paying too much attention to private litigation rather than to the software
business.

How damaging is the report to MS’s legal case?

The judge finds solidly for the plaintiffs. However, the judge’s
argumentation is weak and may be reversed on appeal. The lack of
a clear identification of victims of Microsoft’s actions, and the lack
of presentation of convincing evidence that consumers were harmed are key
weaknesses of the report. Microsoft may have a good chance of a wide
reversal.

What criteria should be applied in determining remedies?

In defining remedies, the following criteria should apply. First, appropriate
remedies have to be proportionate to whatever liability is finally established.
Second, remedies also must be consistent with a strategy that prevents
Microsoft from repeating whatever activity is found to be illegal in the
case. Third, remedies have to be in the public interest and should help
rather than harm consumers. In other words, the treatment should heal rather
than kill the patient. Fourth, remedies should minimize other interference
in Microsoft’s business, and in the business of the rest of the computer
industry. Thus, when defining remedies one has to consider:

What specifically Microsoft is convicted of doing illegally;

Which specific remedies would prevent Microsoft from committing the same
crime or crimes again in the future;

Which remedies help consumers; in discussing whether or not a remedy helps
consumers, one has to consider its effects on prices, on compatibility,
on variety and quality, and on the speed of innovation;

Which of these remedies creates the least interference in the legitimate
business of Microsoft and the rest of the computer industry;

Which remedies preserve and enhance incentives for innovation and technological
progress.

What other considerations should apply in determining remedies?

Long before the present antitrust suit took shape, a loose coalition
of IBM, Sun, Oracle, and Netscape was formed to fight Microsoft. This coalition
has played a very significant role in bringing antitrust issues involving
Microsoft to the attention of Congress and DOJ. In many ways, this coalition
helped DOJ create and fight the case against Microsoft, even providing
the idea of the Boies-Fisher team that had fought for IBM in DOJ’s antitrust
suit against IBM in the 70s. At the time of the remedies determination,
it is crucially important that remedies are not imposed for the benefit
of competitors (including those of this coalition) but rather for the benefit
of the consumers and competition.

What remedies have been proposed and how do you evaluate them?

A number of remedies have been informally proposed by sources close
to DOJ. These remedies range from mild to very severe. The various remedies
also differ to the extent that each deals with horizontal (within the same
market) or vertical (across complementary markets) issues.

Two remedies on business conduct have been proposed.

Conduct remedy 1: Impose various restrictions on the contracts
that Microsoft can write with sellers of complementary goods and with competitors.
This is a likely remedy that is easy to tailor according to the violation.

Conduct remedy 2: Force Microsoft to disclose the APIs (definitions
of the interface) that allow it to include Internet Explorer in the operating
system. Microsoft routinely discloses APIs that hook applications to the
operating system and allow for interoperability. Currently, Microsoft does
not disclose the APIs that tie together parts of the Windows operating
system, which includes Internet Explorer. If the APIs that hook Internet
Explorer to other parts of the operating system are disclosed, Netscape
(and any other browser) can get the same interoperability with Windows
as Internet Explorer. Such disclosure would solve all technological bundling
problems.

Four structural remedies have been proposed.

Structural Remedy 1: Force Microsoft to give away the Windows
source code, or license it to successful bidders in an auction imposed
by the government on Microsoft. Windows code may be worth as much as $200
billion. No company can bid that much. Practically speaking, only a handful
of foreign governments can bid that much. This implies that the source
code of Windows will be sold forcibly at a small fraction of its worth.
Thus, this is a severe remedy that takes away the intellectual property
of Microsoft. It will severely reduce the incentive for innovation, since
dominant firms will no longer be guaranteed with certainty the value of
their intellectual property. Moreover, source code evolves in time. Over
time, different firms will add to and alter the Windows code. Soon, incompatibilities
will arise. Applications vendors will have to write different applications
for each version of the evolving version of Windows. It was exactly this
problem that made Unix a failure in the individual consumer market. It
is unlikely that all applications will be written for each of the incompatible
versions of Windows. If, when there are three incompatible versions of
Windows, each version has 1/3 of the applications, the benefits to a consumer
from using a PC are reduced by 66%! By no means would this be a victory
for the American consumer! In summary, auctioning the Windows code will
result in incompatibilities that harm consumers and increase the cost of
applications.

Structural Remedy 2: Break up Microsoft according to lines of
business. This remedy is favored by the software association. Remedies
that break up a company in any form are very severe. They are likely to
severely damage the company, and they usually accomplish little or no more
than alternative remedies. Microsoft is an entrepreneurial company that
is run by very few top executives (about twenty). This makes it flexible
and efficient, qualities that the DOJ should try to preserve, although
Microsoft’s competitors would probably like to extinguish. Breakup along
lines of business is a very severe remedy. Its function can be accomplished
by disclosure of APIs instead.

Structural Remedy 3: Break up Microsoft in three equal parts,
with each part containing an equal amount of each business. Like other
breakup proposals, this proposal may kill the managerial flexibility and
efficiency of the company. Moreover, as with the auctioning the code proposal,
one expects that significant incompatibilities will result within a short
period of time. Incompatibilities harm consumers by significantly reducing
the benefits that consumers get from applications, as explained above and
by increasing the cost of applications. Finally, it is unlikely that this
industry structure will result in significantly lower prices, since Windows
prices are presently low, and each of the resulting three companies will
have a much smaller scale of production. From a legal standpoint, this
proposal has the weakness of also breaking up the applications division
of Microsoft, although monopolization has not been established in applications.

Structural Remedy 4: Break up Microsoft along lines of business
(operating systems and applications) and then break the operating systems
division in three equal parts. Like other breakup proposals, this proposal
may kill the managerial flexibility and efficiency of the company. It is
also likely to result in incompatibilities, as explained above, with significant
reduction of benefits to consumers, and increases in the costs of application
development.

What do you think is the most likely outcome?

DOJ proposes structural remedies in an attempt to force Microsoft to
settle. But the game is more complicated. And, DOJ lawyers
are amateurs in games of strategy while Gates and his top executives are
professionals. Microsoft has managed over the years to snooker practically
all the major players in the computer industry, including IBM, Apple, and
Compaq. If history is any guide, Microsoft will wait until the present
US Administration fades into history, and will try to cut a deal with the
next Administration. I believe that a conduct remedy, such as contract
restrictions possibly enhanced with API disclosures, is the most likely
outcome.